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Lifecycle dynamics of income uncertainty and consumption

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  • James Feigenbaum
  • Geng Li

Abstract

Uninsurable income risk is often cited as an explanation for empirical deviations from the Lifecycle/Permanent-Income Hypothesis such as the observation that the life-cycle profile of mean consumption is hump-shaped. Most methods used for estimating income uncertainty essentially measure the cross-sectional variance of a subpopulation rather than the true uncertainty or riskiness perceived by consumers. In this paper, we employ a nonparametric approach to estimate idiosyncratic income uncertainty. We measure income uncertainties as the variance of income forecasting errors at different ages and over different time horizons. The estimated life-cycle income uncertainty profile is U-shaped and generally implies a lower degree of income uncertainty relative to the previous literature. We subsequently use these nonparametric estimates to calibrate a (time-inconsistent) lifecycle model to assess whether a consumption hump can be generated by precautionary saving given more robust measures of income uncertainty. We show that, with plausible risk aversion coefficient and discounting factors and an endogenous, rarely active borrowing limit, our refined measure of income uncertainty is large enough to generate a significant consumption hump that peaks around age 55 and closely matches with the observed magnitude of the consumption hump. We also notice that the variation in the volatility of income shocks with respect to both age and forecast horizon has a significant impact on the size and peak age of the consumption hump.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2008-27.

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Date of creation: 2008
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Handle: RePEc:fip:fedgfe:2008-27

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Keywords: Consumption (Economics) ; Income;

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Cited by:
  1. Emin Gahramanov & Xueli Tang, 2014. "Impatient in Experiments, but Patient in Simulations: A Challenge to a Neoclassical Model," Economics Series 2014_2, Deakin University, Faculty of Business and Law, School of Accounting, Economics and Finance.
  2. Abe, Naohito & Yamada, Tomoaki, 2009. "Nonlinear income variance profiles and consumption inequality over the life cycle," Journal of the Japanese and International Economies, Elsevier, vol. 23(3), pages 344-366, September.
  3. James Feigenbaum & Geng Li, 2011. "Household income uncertainties over three decades," Finance and Economics Discussion Series 2011-25, Board of Governors of the Federal Reserve System (U.S.).
  4. Geng Li & James Feigenbaum, 2009. "A Nonparametric Characterization of Income Uncertainty over the Lifecycle," 2009 Meeting Papers 464, Society for Economic Dynamics.
  5. James A. Feigenbaum & Geng Li, 2010. "A semiparametric characterization of income uncertainty over the life cycle," Finance and Economics Discussion Series 2010-42, Board of Governors of the Federal Reserve System (U.S.).

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